A company desires to replace its current plant equipment with new equipment that

Question

A company desires to replace its current plant equipment with new equipment that costs $10,000,000. One possibility would be for the company to issue $10,000,000 of bonds and use the proceeds to purchase the equipment. Another possibility would be for the company to raise $10,000,000 by issuing common stock. And a third possibility is to acquire the use of the equipment by signing a long-term capital lease with a leasing company. Describe and compare the financial statement effects along with the relative advantages and disadvantages of these alternatives. Which approach would you choose and why?

Explanation / Answer

Issue bond

Advantage: Bond has low cost compared to other financing options such as equity.

Disadvantage: This puts a pressure on the company financial risk, ie gearing. When a company has high gearing, it may have difficulty in meeting various obligations whether short term and long term.

Issue common stock

Advantage: There is no obligation to pay dividends to ordinary shareholders.

Disadvantage: Equity holder may demand for higher return (in the form of dividend) to compensate their risk (being the last to claim back their capital in the case of liquidation). Also, the company must be a financial sound company so that raising equity finance is possible.

Long term capital lease

Advantage: This ease the company cash flow by avoiding the need of paying large amount of money in a short term to buy the new equipment. Instead, a smaller amount of monthly instalment is paid over a long period.

Disadvantage; There will be interest cost associated with finance lease. The interest cost associated may be very high where a company may not be able to earn such return via other investment.

Hope this helps!

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